Principles of economics openstax chapter16

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Information, Risk, and
Insurance
Chapter 16


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Chapter Outline
n 

The Problem of Imperfect Information and Asymmetric
Information

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Insurance and Imperfect Information


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Imperfect information and
asymmetric information
n 

Asymmetric information: where both parties involved in an
economic transaction have an unequal amount of information (one
party knows much more than the other)
n 

n 

E.g. Buying a used car

Imperfect information: either the buyer, the seller, or both, are
less than 100% certain about the qualities of what is being bought
and sold


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Imperfect vs asymmetric
Imperfect Information

Asymmetric Information

n 

buyers and/or sellers do
not have all of the
necessary information to
make an informed decision
about the price or quality of
a product

n 

one party, either the buyer
or the seller, has more
information about the

quality or price of the
product than the other
party.

n 

“Lacking”

n 

“Unequal”


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Lemons – Used Car Market
n even

with imperfect information, prices still
reflect information

n used

cars are more expensive on some dealer
lots because the dealers have a trustworthy
reputation to uphold (signal)

n individual

seller has no reputation to defend

(Craigslist)


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Imperfect information – Labor
markets
n 

How can a potential employer screen for certain attributes, such
as motivation, timeliness, ability to get along with others, and so
on?

1. 

Trade schools and colleges to pre-screen candidates.

2. 

Only interview a candidate with a degree and, sometimes, a
degree from a particular school.

3. 

View awards, a high grade point average, and other accolades
as a signal of hard work, perseverance, and ability.

4. 

References for insights into key attributes such as energy level,
work ethic, and so on.


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Imperfect information - impacts
n Equilibrium

Price and Quantity

n  Thin

markets (few buyers and sellers) as each is
hesitant due to uncertainty as opposed to thick
markets (many buyers and sellers)

n Price

as a signal of quality

n  E.g. Expensive

restaurants


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Imperfect Information - Fixing
n  Product

n 

Reputation, guarantees, warrantees, and service contracts
n  Guarantees assure quality (promised)
n  Warranty – promise to fix defect over a limited time
n  Service Contract – pay extra to assure repairs

n  Labor
n 

quality assurance

Markets

occupational licenses and certifications to assure competency;
probationary periods

n  Financial
n 

n 

Markets

cosigners and collateral

Federal Trade Commission – against advertisers making false
claims as truth

+ Insurance and Imperfect
Information
Section 16.2


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Insurance
n 

Insurance: a method that households and firms use to prevent any
single event from having a significant detrimental financial effect.

n 

Premiums: Regular payments made by households or firms with
insurance
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Based on probability of event occurring
Pooled and paid out to those affected by the covered event if it occurs

n 

E.g. Health insurance, Life insurance, Auto insurance etc.

n 


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How insurance works

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100 people insured; three risk groups; three possible outcomes

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Total damage = (60 × $100) + (30 × $1,000) + (10 × $15,000)
= $600 + $30,000 + $150,000
= $186,000

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If each of the 100 drivers pays a premium of $1,860 each year, the
insurance company will collect the $186,000 needed to cover the
costs of the accidents that occur. Average premiums and average
insurance payouts must be approximately equal.

n 

approximately equal.


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How insurance works
n  Risk

group: a group that shares roughly the same risks
of an adverse event occurring.

n  Insurance

companies often classify people into risk
groups, and charge lower premiums to those with
lower risks

n  If

could classify people according to risk group,
then each group can be charged according to its
expected losses – high risk, pay higher premiums


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Imperfect information in insurance
markets
n 

Moral Hazard : when people engage in riskier behavior with
insurance than they would if they did not have the insurance.

n 

E.g. with car insurance, drivers drive less careful than without

n 

Cannot be eliminated, but insurance companies can attempt to
reduce it:
1. 
2. 
3. 
4. 

n 

Monitor behavior to manage risk – security system lowers premiums
Deductibles - amount that the insurance policyholder must pay out of
their own pocket before the insurance coverage starts paying
Copayment - policyholder must pay a small amount
Coinsurance - insurance company covers a certain percentage of the
cost

When faced with copays and deductibles, studies find reduction in
moral hazard (less consumption of covered service)


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Moral Hazard – health insurance
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Fee – for – service: medical care providers are paid for the
services they provide and are paid more if they provide
additional services.
n 

n 

n 

Traditional way of providing health care in the US
Lately more shift to health maintenance organizations (HMOs)

Health Maintenance Organization (HMO) provides
healthcare that receives a fixed amount per person enrolled
in the plan—regardless of how many services are provided
n 

Consumer still has incentive to demand more services; provider
has incentive to limit it.


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Adverse Selection
n 

Adverse selection - the problem in which the buyers of
insurance have more information about whether they are highrisk or low-risk than the insurance company does.

n 

Asymmetric information problem for insurers

n 

E.g. With $1860 premium cost from previous example, only high
risk group will get insurance (expected loss greater than $1850,
while others have expected cost less than $1860, so insurance
company can not pool risk, i.e. take from lower risk and pay to
higher risk

n 

May refuse high risk individuals, or offer insurance at very high
rates – as was the case with healthcare in US before 2010


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Affordable Care Act 2010
n 

If insurance premiums are set at actuarially fair levels, people
end up paying an amount that accurately reflects their risk
group, certain people will end up paying a lot or not offer it
to those with pre-existing conditions – not allowed under
ACA

n 

High premiums – not all get insurance (adverse selection) –
mandated now (50+ employees must offer insurance)

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State insurance exchanges – for competition of plans

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Paid for by higher taxes, annual fees on providers


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Review Questions


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Review Questions
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Q6. What are some of the ways a seller of goods might reassure
a possible buyer who is faced with imperfect information?
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Q7. What are some of the ways a seller of labor (that is,
someone looking for a job) might reassure a possible employer
who is faced with imperfect information?
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Solution: Offering warrantees or a period of time in which to return the

product for a full refund might correct for the buyer’s lack of information.

Solution: The worker may offer to work for a trial period for little or no
wages so that the employer can verify his value before signing a longterm contract.

Q8. What are some of the ways that someone looking for a loan
might reassure a bank that is faced with imperfect information
about whether the loan will be repaid?
n 

Solution: People looking for loans typically have to show evidence of a
steady income or the possession of collateral, such as a property owned,
so that the bank can be assured of collecting on its loan.


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Review Questions
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Q 11. What is an actuarially fair insurance policy?
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Q 12. What is the problem of moral hazard?
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Solution: An actuarially fair policy is one in which the average benefits
paid out equal the average cost to the policy holder.

Solution: Moral hazard is the observation that people behave in more
risky ways when the cost of risky behavior is decreased.

Q 13. How can moral hazard lead to insurance being more
costly than was expected?
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Solution: When people are insured, they engage in more risky
behavior, leading to higher costs for the insurer and thus higher
premiums for the policy holder.


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Problem - # 24
Imagine that 50-year-old men can be divided into two groups: those
who have a family history of cancer and those who do not. For the
purposes of this example, say that 20% of a group of 1,000 men have a
family history of cancer, and these men have one chance in 50 of dying
in the next year, while the other 80% of men have one chance in 200 of
dying in the next year. The insurance company is selling a policy that
will pay $100,000 to the estate of anyone who dies in the next year.
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a. If the insurance company were selling life insurance separately to
each group, what would be the actuarially fair premium for each
group?

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b. If an insurance company were offering life insurance to the entire
group, but could not find out about family cancer histories, what
would be the actuarially fair premium for the group as a whole?

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c. What will happen to the insurance company if it tries to charge the
actuarially fair premium to the group as a whole rather than to each
group separately?


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Solution
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a. For the high risk group, the premium would be the probability
of dying 0.02 times the benefit payment $100,000 = $2,000. For
the low risk group this would be 0.005 x $100,000 = $500.

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b. We weight the premiums for the two groups by frequency in
the population and add the results together. $2,000 x 0.2 + $500
x 0.8 = $800.

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c. The high risk group will recognize that they are getting a
good deal, since $800 is less than their actuarially fair rate of
$2,000, so they will enroll in high numbers. Meanwhile, the low
risk group will be less likely to enroll, since the rate is higher
than their actuarially fair rate of $500. This adverse selection
problem will cause the insurance company to either lose money
or have to raise rates still higher.